Wednesday, June 14, 2017

Arecent
speechgiven in Tokyo by St.
Louis Federal Reserve Bank President, James Bullard, looks at one of the great
concerns facing the Federal Reserve, the lack of inflationary pressures in the
U.S. economy. You may ask, why would this be a problem? After all,
wouldn't it be great if the price of goods and services remained steady or even
declined? In the world of central banking, any signs that prices could
drop is considered extremely dangerous because of the impact of dropping demand
on the economy.

Let's
look at deflation for a moment. In our inflationary world, we've grown
accustomed to purchasing goods and services when we want them because, in our
reality, the price of the good or service is likely to rise in the future so
there is no need to postpone our purchase. In a deflationary world, there
is motivation to postpone purchasing a good or service since the price is
likely to drop in the future. This lack of immediacy means that demand
drops along with prices, slowing down economic growth. As well, inflation
helps reduce debt because debt is paid with future dollars that are cheaper, in
other words, the debt is "inflated away". In a deflationary
environment, the opposite is true; debt becomes more expensive in the future, a
scenario that sends shudders through the hallowed halls of governments and
businesses around the globe.

In
James Bullard's latest speech, he looks at recent developments in inflation.
It is particularly interesting that he gave this speech in Japan, a
nation that has suffered from a prolonged period of ultra-low and even negative
inflation (deflation) as shown onthis graphic:

Despite
the Bank of Japan's best efforts, they have simply been unable to prod the
Japanese economy back into an inflationary pattern.

Now,
let's get back to the topic of this posting; James Bullard's view on inflation
in the United States. Here is a graphic from his presentation showing how
the expectation of inflation has weakened substantially since the beginning of
2017:

Here
is a graphic showing how several measures of inflation (measured in basis
points) have dropped since December 2016:

In
general and historically speaking, when unemployment is dropping, inflationary
pressures increase because businesses must compete for workers by raising
wages, a relationship that is expressed in the Phillips curve. These
higher costs are then passed along to consumers in the form of higher prices.
Hereis a graph showing the relationship
between the year-over-year change in the core PCE inflation versus the
civilian unemployment rate:

Mr.
Bullard notes that the unemployment rate hit a low of 4.3 percent in May 2017,
a level that would normally cause inflationary pressures. He also
speculates that the current low unemployment rate is unlikely to spark
inflationary pressures because arecent study by Olivier
Blanchard suggests that:

1.)
Inflationary expectations...have become steadily more anchored, leading to a
relation between the unemployment rate and the level of inflation rather than
the change in inflation.

2.)
The effect of the unemployment rate on inflation given expected inflation has
substantially declined since the 1980s.

Rather
than being tied to the unemployment rate, inflation now depends on long-term
expected inflation rather than past inflation and long-term expected inflation
now depends little on past inflation. As well, when looking at the
influence of unemployment on inflation, as the level of inflation has decreased
over the past three decades, wages and prices have changed less often which
leads to a smaller response of inflation to labor market conditions.

From
Mr. Bullard's presentation, here is a graphic showing the estimated influence
of various levels of unemployment on inflation:

As
you can see, even a substantial drop in unemployment is expected to have little
impact on inflation.

Here
is a graph showing how the United States economy has fallen well below the 2
percent inflation target set by the Federal Reserve since 2012:

As
you can see, the current price level is 4.6 percent below the Fed's preferred
inflation pathway.

In
comparison, here's what happened to Japan's inflation:

While
the U.S. economy has not suffered from low inflation/deflation to the same degree as
Japan's economy, the trend is, in Mr. Bullard's terminology,
"worrisome" just as Japan's deflationary worries began in the mid to
late 1990s.

In
closing, Mr. Bullard notes that the current low unemployment readings are
"probably not an indicator of meaningfully higher inflation over the
forecast horizon", an issue that could well prove to be a problem for the
world's most influential central bank. While the U.S. economy is not yet
experiencing the deflationary nightmare that has been and is still being experienced by the Bank
of Japan, it certainly looks like it is heading in a direction that is
unpalatable to the Federal Reserve.

1 comment:

The idea that inflation cannot exist in a period of slow growth is a myth that many people believe, this may soon be proven false. The concept a little inflation is a good thing appears to be based on the idea it adds to the illusion of overall economic growth.

The world central banks have created an environment where stagflation may flourish. When it comes to economic policy it seems, sustainability has been put on the back burner and the goal of creating growth at any cost has taken center stage. For more on this subject see the article below.

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.